Friday, 29 June 2012

There
is a lot that is interesting in Diane Coyle’s 2012 Tanner lectures.
What I want to respond to here is an associated post,
where she expresses some of the frustrations that I know many microeconomists
have with macroeconomics. These can be summed up rather crudely as: why do we
disagree all the time, and yet appear so sure we are right, and don’t we
realise we are bringing the whole discipline into disrepute? Diane says that “macroeconomists
simply do not realise how low their stock has sunk in the eyes of their
microeconomist colleagues”.This
may be an exaggeration, but who knows what is said when we are out of earshot.
Because I (and pretty well all macroeconomists) do have great respect for our microeconomic colleagues, we have some explaining to do. (Jonathan Portes has
an excellent post
responding to some of the more specific comments Diane makes in this post.)

What I
want to say in summary is this. Microeconomists are right in many of their
criticisms, but what they often fail to see is the root cause of the problem.
This is that macroeconomic policy is highly political, with strong ideological
implications. Ideology and politics distort macroeconomics as a science. Yet
despite this, there is – and for many years has been – a substantial body of
analysis that most macroeconomics would sign up to, and which has
sound empirical backing.

What is
this substantial body of analysis? It is what used to be called the new neoclassical
synthesis (Goodfriend and King (1997) – see here
for more background and references). For a closed economy, its details are well
represented in Romer’s graduate textbook, for example. This body of analysis
has important gaps and omissions, of course, such as a naive and simplistic
view of the financial sector. However, as I argued recently,
the financial crisis itself showed up this incompleteness, but did not
invalidate most of what was in the synthesis. Indeed, events since the crisis have
provided significant empirical support for the Keynesian elements of that
synthesis. (Of course, there are caveats, some of which I have discussed in earlier posts,
and which I will return to below.)

So why
the appearance of constant disagreement among macroeconomists? The first point
to make is that the disagreement tends to focus on one part of the synthesis,
which is short term macroeconomic fluctuations: their causes and cures. This is
not the only part of the synthesis which has the potential for political and
ideological controversy, but it is where there is constant popular and media
interest. The second point, however, is that politics alone is not sufficient
to explain controversy within a scientific discipline. Here I might give
climate change is an example: despite strong pecuniary temptations, climate
change science is pretty united, and typically dissenting views come from outside
the discipline.

The
reason, I would suggest, why many macroeconomists do not sign up to the new
neoclassical synthesis is that its Keynesian component conflicts with an
ideological view which uses economics as part of its intellectual foundation. That
view is that markets generally work well when left free from political
interference and that government intervention is almost always bad. Now most microeconomists
will immediately point out that microeconomic theory as a whole does not
support this ideological view. Much microeconomic analysis is all about market
imperfections. But that misses the point. Those attracted to this ideological
position use a very partial take on economics for support, and are naturally
attracted to that part of the discipline.

Keynesian
analysis is all about the consequences of one particular market imperfection. Conventionally
this is seen as the externalities that arise from sticky prices. (I personally am
increasing drawn to describe them as the consequences of the existence of money,
but that is a different story.) It implies in general the need for constant
involvement of one arm of the state – the central bank – in stabilising the
economy, and in some circumstances the involvement of fiscal policy to do the same.
I have argued
that this analysis leaves those with the ideological view that free markets are
good and government intervention bad feeling very uncomfortable, so they will
try and find ways of avoiding and disputing this part of the synthesis.

Now
nothing I have said so far makes macroeconomics unique in attracting
ideologically driven controversy. There are areas of microeconomics which are
equally controversial for similar reasons. I would suggest the debate over
minimum wages is an example. An outsider looking at this debate might well
conclude that labour economists are as equally disputatious as macroeconomists on
this issue. Another example from my youth I always like to use is the ‘Cambridge
controversies’ over ‘reswitching’. This was a highly technical theoretical dispute,
but its ideological implications were such that views on this technical debate
were highly correlated with political beliefs.

I think
there is one factor that is peculiar to macroeconomics, and that is the role of
‘city’ economists. There are two elements here. One is that city economists
work in an environment which has a strong vested interest in promoting the free
market ideological view. The other is that part of the name of the game for
these guys is to differentiate the product. These are of course tendencies:
there are many excellent city economists who go with the evidence rather than
with ideological conviction.

Why is
it important to say all this? First, because the influence of ideology on
economics is not confined to macroeconomics. It is also not confined to the
political right, so there is no simple bias, but recognition rather than denial
is important. Second, the cure – if there is one – is evidence. As Jonathan
points out, the recent evidence is clearly with those who accept Keynesian
views, but I think there is an underlying problem. The way empirical evidence
is marshalled in the microfoundations methodology associated with DSGE
modelling makes it too easy
for those who hold ideologically based priors to retain and defend those priors,
which is one reason why I have tried
to suggest that it should not be the only way serious macroeconomic analysis is
done.

Tuesday, 26 June 2012

In
an earlier post,
I used recent UK experience to suggest looking at other inflation measures
besides consumer prices. The two widely published alternatives are the GDP
deflator (the price of all that is produced rather than consumed in an economy)
and average earnings/wages. The reason I gave for looking at these other
inflation measures was purely pragmatic. Some shocks (like value added tax or
commodity price changes) could have a significant impact on consumer prices,
but it was difficult to know whether their impact is just temporary or whether
they could initiate something worse. Looking at output prices and wages would
give you a much better handle on that.

But
consumer prices are what ultimately matter, right? They are what we care about.
Well no, not necessarily. Individuals as consumers do not like consumer prices
going up, but wages going up are good for individuals as workers, unless they
are someone else’s wages. The first
thing we need to do is distinguish between inflation in an abstract sense and
movements in real variables. (The two may be associated, of course, which may help explain public attitudes.)

For economists, inflation is the phenomenon
where, over some period, all nominal magnitudes are rising together, without
any particular implications for real incomes. There are a number of reasons why
inflation so defined may be costly. One is that holding money becomes more
expensive, because its purchasing power decreases with inflation. In this case
a focus on consumer prices is probably correct. But there is another cost of
inflation where the source of inflation does matter.

It has been
known for some time that inflation goes hand in hand with greater variability
in relative prices. To the extent that inflation causes this relative price
variability, it is costly, because relative price changes caused by inflation
alone distort the market mechanism. One clear reason why this might happen is
that many prices are changed infrequently at different times. If the price of
good X is changed each April, and the price of good Y is changed each October,
then inflation will cause good Y to be too cheap relative to good X in the
summer and too expensive in the winter. There is no reason in terms of supply
or demand for this pattern in the relative price of X in terms of Y, so if it
leads to changes in consumption or production it misallocates resources. The
higher the rate of inflation, the greater this misallocation cost.

Is this cost of inflation
important? Keynesians certainly believe that slow or 'sticky' price adjustment
is pervasive, and is largely responsible for generating persistence in business
cycles. The reasons why many prices are sticky appear diverse and complex, but
imperfectly competitive markets do seem to be important. In recent years a
number of Keynesian economists (following pioneering work by Michael Woodford
in particular) have attempted to quantify the costs of the relative price
movements generated by inflation and sticky prices, and these calculations
suggest that changes in inflation generate significant changes in social
welfare through this route. This means that the type and source of inflation is
important. If inflation occurs in commodities where prices are changed
frequently, then it is much less costly than if inflation occurs in prices that
are sticky. In other words, some types of inflation are more costly than
others.

This focus on
inflation in goods where prices are sticky bears some relation to the idea of
focusing on 'core' inflation[1].
It is possible using similar reasoning to argue that the price inflation
measure central banks should target is actually output prices (the GDP
deflator) rather than consumer prices.[2] (If there are trends in relative prices, then
this idea also influences the optimal inflation target: see Alexander Wolman here,
for example.) The same type of argument also suggests that central banks should
be concerned with wage inflation as well as price inflation.[3]
This is because wages are themselves 'sticky', and so wage inflation will
generate costs by changing relative wages in a distortionary manner just as
price inflation causes distortionary relative price changes. All this is
explained clearly, in considerable technical detail, by Michael Woodford here.

To see why this
is important, consider the recent impact of higher oil prices. This has a
direct and fairly immediate impact on inflation. A hard-line inflation targeter
would say that an inflation target is an inflation target, so the monetary
authority should try and make non-oil price inflation fall to offset the impact
of higher oil prices. However oil prices, and some things they influence like
petrol prices, are pretty flexible. If inflation is costly because it induces
unnecessary relative price distortions in prices that are sticky, then it makes
sense to focus on inflation measures that give much less weight to oil prices
than the consumer price index. In other words, core inflation is not just useful because it helps predict longer term trends in actual inflation, it is important because it actually matters more than actual inflation.

Friday, 22 June 2012

I was asked the other day
how macroeconomics teaching at Oxford had changed as a result of the Great
Recession of 2008-9. My answer, which was not much, seemed a little surprising at first.
Does this reflect insularity or intellectual arrogance? Surely the failure to foresee
the financial crisis must have led to some change in what was taught. Does this
not confirm something
rotten at the heart of economics?

First I
need to explain ‘not much’. [In what follows I only deal with core macro courses, and not options at either undergraduate or graduate level.] John Vickers, who gives the first year macro
lectures, has added material on bank runs, leverage and banking reform, where for the latter he has of course played a major role in current UK
policy. My own second year undergraduate lectures include a wealth of topical
examples to illustrate basic theory. And perhaps most significantly, Martin
Ellison now gives a couple of weeks of lectures on recent developments in
modelling financial frictions as part of the core post-grad macro course.

So why
was my answer not much? Because although the crisis has added material, nothing
has really been thrown away as a consequence of what has happened. We have not,
either individually or collectively, decided that the Great Recession implies
that some chunk of what we used to teach is clearly wrong and should be
jettisoned as a result. Speaking for myself and my second year undergraduate
lectures, quite the opposite is the case. As Paul Krugman has pointed out many
times, recent developments have in many ways been a vindication of the basic
Keynesian model that lies at the heart of any undergraduate macro course.

Indeed,
I would go even further. The mess we are currently in is due in part to policy
makers ignoring this basic macroeconomic analysis. As a result, I teach this
stuff with renewed vigour and determination. As many people know, both our
current Prime Minister and the Leader of the Opposition will have attended a
past version of the course I teach (although well before, I hasten to add, I
started teaching it). Although George Osborne read Modern History at Oxford
(and here ‘modern’ means from 1330, so the Great Depression was not necessarily
covered in depth!), one of his principle advisors also read PPE (Politics,
Philosophy and Economics). If any future Prime Minister or Chancellor follows a
similar path, I want them to remember basic macro theory.

Now I
also teach the first part of the core macro for our MPhil (Oxford’s two year
masters) course, and you might think that the basic Ramsey model which is
covered there has less relevance to recent events. To some extent this is true:
I’ve noted
how the standard intertemporal consumption model is not going to explain trends
in savings in the UK or US over the last few decades, and my colleague John
Muellbauer has written extensively
on this. On the other hand, I find the Ramsey model and its OLG variant very
useful in discussing issues around the control of government debt.

So
while the Great Recession has clearly shown that macroeconomics is incomplete
in important respects, it has not shown that what we thought we knew is all
wrong. In many respects it has shown it is
exactly right.

However
I think I should add one important rider to this. Anyone wanting to understand
what has happened over the last five years would be better off reading an
undergraduate macro textbook like Mankiw than a masters textbook like Romer.
This is not because the former is less technical than the latter, but because
the former is more old fashioned in academic terms. They might do even better still
by reading The General Theory. Before I am misunderstood, I am not suggesting
anything is wrong with what we currently teach. Rather that the inevitable focus
at the masters level on the recent macroeconomic literature leaves no place for
the history of macroeconomic thought, and that is a problem.

Now I
must confess two things here. First, I have not always held this view. Indeed until
quite recently, when I thought
most macroeconomists signed up to the New Neoclassical Synthesis, I imagined
economics might be like a physical science, where knowledge of bygone theory added
little to our understanding of the world today. The Great Recession changed
that view, for me at least. Second, this argument to teach the history of
macroeconomic thought is one that tends to be made by those of a certain age, and
even though they might also be very eminent (for example),
don’t we all want to pretend we are still young? Well maybe it’s time to admit
my age.

Monday, 18 June 2012

Unfortunately I cannot find the
written source (if any exists), but I am sure I have heard Mervyn King say,
probably before he became Governor, that the one thing central bankers hate
more than inflation are budget deficits. One rationale for this attitude is that
central banks see themselves as playing a game with the fiscal authorities.
Governments may be tempted, because they are not benevolent, to occasionally
ignore debt when setting fiscal policy. If the monetary authority monetises
that debt, this behaviour may be encouraged. This matters because an outcome
where the fiscal authority always ignores debt is very bad. (It is very bad if
the central bank gives in, because it will lead to inflation. If the central
bank does not give in, it is very bad either because it leads to a debt
explosion and default, or – if you follow the Fiscal Theory of the Price Level
- because you get inflation anyway. I do not think it matters in this context
which bad it is – see
McCallum and Nelson for an example from this debate.)

If we want to prevent this very
bad outcome, so the argument goes, it is important that the monetary
authorities do nothing to encourage this fiscal policy behaviour. In purely macroeconomic
terms, there may well be occasions when it is efficient to use interest rates
to help reduce the debt stock – particularly when the debt stock is high. One
half of what I call the consensus assignment – that monetary policy should have
nothing to do with debt control – therefore needs to be justified by arguments
with a more political economy flavour. This particular political economy argument
is the one I helped put forward in more detail here.

This concern about not doing
anything to encourage ‘fiscal indiscipline’ is likely to be particularly acute
at the moment because of Quantitative Easing. Printing money at a time of large
budget deficits can be interpreted as fiscal dominance, so it becomes all the
more imperative that the monetary authority draw a line in the sand by insisting
that QE is temporary, and reinforcing that by sticking rigidly to their
inflation targets.

The trouble is that what the
world economy needs right now is a bit of what looks like fiscal dominance.
(Brad DeLong thinks along similar lines here.)
We need a temporary increase in inflation above target. As I have argued before,
by focusing on inflation, and ignoring the output gap, central banks are not
maximising social welfare as we normally understand it. So how do you convince
central banks that their concern about fiscal dominance needs to be set to one
side?

One of the potential strengths of
the UK monetary policy regime is that you do not have to. The inflation target
is set by the government. As I have said before, I do not know why the UK
government (and the opposition) is not even thinking about changing the 2%
target. If the answer is that it would be politically too difficult to sell,
that becomes a very strong argument against democratic control of macroeconomic
policy!

Where central banks do have control of the
inflation target, one argument that could be used is that it is quite unusual
for governments to persistently and completely ignore debt when setting fiscal
policy (see this
research for example). Unfortunately I do not think this line will be very
persuasive. Quite unusual does not mean never: see Greece most recently. Even
in the US, when a good part of one of the main political parties shows a
similar disrespect for numbers and facts as some in the Greek government showed
before 2007, anything is possible.

The argument I would use with
central bankers is this. Fiscal dominance becomes a problem when the output gap
is zero or positive, and not when we have demand deficiency. So allow inflation
to rise conditional on the existence of a significant negative output gap (or
high involuntary unemployment). This could be done
through a nominal GDP target, but it does not have to be done this way.

As regular readers of this blog
will know, one of my persistent themes
is that with fiscal policy we should separate short term issues of
stabilisation from long term issues of debt control. Having a fiscal stimulus
in a liquidity trap need not compromise long term fiscal discipline. When the
long term problem gets mixed up with short term stabilisation, we get bad
results. Exactly the same is true for monetary policy and long term fiscal policy: we should not let an obsession about fiscal discipline distort what
we do on short term stabilisation. Central bankers understand that questions of
moral hazard have to be put to one side in a banking crisis, so why is it so
difficult to see that the same point applies in a macroeconomic crisis?

Friday, 15 June 2012

“Of course, there are those who argue we should not be
reducing the deficit – we should be spending and borrowing even more. But that argument
ignores a crucial fact: inflation in the UK has been significantly above the
Bank of England’s 2% target since the end of 2009. That is due to a combination
of commodity price shocks, the lagged effects of a lower exchange rate and a
worsening underlying productivity performance, and it has very important
implications for fiscal policy. Looking backwards it means that over this
period looser fiscal policy would almost certainly have been offset by tighter,
or less loose, monetary policy.”

This is an argument I have
already discussed,
but it is the first time I have seen the government use it. It is an improvement
on those based on bond markets, confidence fairies, or expansionary fiscal
contraction. Yet even if you buy it (which I do not think you should), the key
phrase here is ‘looking backwards’.

In
judging policy, we should not look backwards. Lots of things are true in
hindsight, whereas policy has to be made under uncertainty. Good policy should be as robust as possible to this uncertainty. In 2010, when additional
austerity was announced, the government did not know that inflation was going
to be unexpectedly high in 2011. So it cannot have known that the MPC would have been debating whether to increase interest rates in the spring of that year. A more likely outcome was that inflation would be falling and interest rates would be firmly anchored at their lower bound. As a result, high inflation in 2011 is a poor excuse for a bad decision.

It was
a bad decision because the government should, at the very least, have considered the possibility
that demand was going to be weaker than they expected, and that monetary policy
would be unable to do much about it because interest rates were at the zero
lower bound. If they did not think about this possibility, it was
irresponsible. If they did and took a risk, we are now experiencing the
consequences.

The
Chancellor in his speech also quoted Mervyn King as saying that current UK policy
was a “textbook response” to the current situation. I do not know where that
quote comes from (it is not in the text of the Governor’s speech at the same occasion),
so I will focus on what the Chancellor thinks. He goes on to explain: “Theory and evidence suggest that tight fiscal
policy and loose monetary policy is the right macroeconomic mix to help
rebalance an economy in the state [of high indebtedness].” To which I
can only say – no, not when interest rates are stuck at zero.

Central
banks get a lot of criticism: some justified, some not. When it comes to what
monetary policy can do in a liquidity trap, they do not want to appear too
pessimistic. But there is a danger of giving the opposite impression, which is
that nothing much has changed except the way policy is implemented. I would
much prefer them to be quite explicit about how much more uncertain
Quantitative Easing is as an instrument, and that fiscal policy will have a
much greater impact on demand as a result.

Regular
readers may think I’m beginning to sound like a record on this. Indeed,
Jonathan Portes argues
that the proposed new programme discussed yesterday by the Chancellor of government guarantees to support new
house-building and infrastructure investment concedes the intellectual
and economic argument. To quote: “The economic difference between the
government borrowing from the private sector to finance investment spending,
and the government guaranteeing the borrowing of another entity - with the
government guarantee meaning that the lender has no more or less risk of
non-repayment than if the money was lent direct to government - is marginal.” If
the new investment happens, I would agree.

I also suspect that Mervyn King
would not describe such schemes as pure monetary policy. He says:
“But the long term nature of the lending and its pricing mean that the Bank
could conduct such an operation only with the approval of the Government, as
offered by the Chancellor earlier. So such a scheme would be a joint effort
between Bank and Treasury. It would complement the government’s existing schemes,
and tackle the high level of funding costs directly.” That sounds like code for this
is also fiscal policy.

But why quibble. If measures of
this kind allow the government to carry on the fiction that they are sticking
to Plan A, and if it produces a recovery which it is then claimed has nothing
to do with fiscal policy, should we mind? I think we should, because today’s
myths have a danger of becoming tomorrow’s received wisdom.

Thursday, 14 June 2012

I’m often asked about
helicopter money, and occasionally there are calls for this policy to be
implemented. (Here
is a recent example.) The way I think about this, at a very basic level, is
that it is equivalent to a call for a temporarily higher inflation target.

Think of an economy with
just consumption and a government. Consumers are Ricardian. The government
issues money and indexed debt, and it pays the interest on debt using lump sum
taxes. There are two periods. The second period has flexible prices, but the
first involves sticky prices, a demand deficiency and a ZLB.

In this
set up, a tax cut in the first period financed by issuing debt does nothing,
because taxes rise in the second period to pay back the debt. What happens if
the tax cut is financed by printing money? Prices must rise in the second
period as money is the only nominal quantity, such that real balances in the
second period are unchanged. What about the first period? Taxes have fallen, so
it is tempting to say that lifetime income must have increased. However that
tax cut needs to be kept in the form of cash, and not spent, because prices are
going to rise diluting holdings of real money. So people save that tax cut as
money. (I guess it’s like the Ricardian case, except it’s the inflation tax
that you are saving for.)

However
there is a real effect in the first period, because with nominal rates at the
ZLB, higher expected inflation reduces real interest rates, which means it’s
sensible to bring forward some consumption into the first period. So helicopter
money works through raising expected inflation, and not through any income
effect, in this very simple set up. I think this is consistent with some old
posts by Tyler
Cowen and Brad
DeLong. (There is a paper by Buiter (NBER 10163) which talks about this
issue, but my pdf reader does not recognise the WPMathA font, so I cannot read
the maths. If anyone can help me here I’d be very grateful.)

In this
very simple context, calls for helicopter money are equivalent to calls for a
temporary increase in the inflation target. The policy only works because
inflation increases. If the
government printed money to spend on its own goods and services in the
first period, then there would be a direct positive demand effect in addition
to the inflation effect, but this direct demand effect could be achieved by a balanced
budget fiscal expansion, without the need to print money.

If the
government cut taxes by printing money, but then reduced the stock of money back
again in the second period by raising taxes, then nothing happens in this
simple model. The fact that there is more money in the first period does
nothing, and consumers are no better off. We do not have any of the
imperfections and margins in this simple model that QE is thought to work on in
the real world.

QE involves a temporary exchange
of bonds for money, if we consolidate the government and central bank. How do
we know it’s temporary? First, because central bankers say it is. But, second
and more importantly, because central banks appear totally wedded to their
inflation targets. Data on inflation expectations suggest this is also what the
private sector believes. If QE was not temporary, we would get the equivalent of
helicopter money. In the QE case, and unlike helicopter money, the bond stock
falls, but we can get back to helicopter money by cutting taxes by issuing
bonds, which as the model is Ricardian does nothing.

So it
seems to me that calls for helicopter money are isomorphic to calls for a
temporary increase in the inflation target, and none the better or worse for
that. But if I’m missing something important here, do let me know.

Saturday, 9 June 2012

that either
makes visitors lose their critical faculties, or non-visitors like myself and Paul Krugman lose theirs. In my earlier post,
I was not that surprised that a member of the ECB’s Executive Board would
trumpet Latvia’s ‘success story’, because that fitted the party line. I was a
little more surprised to find the head of the IMF saying
similar things, because the IMF has been rather more realistic about the
consequences of austerity and internal devaluation. (Although the contrast
between the IMF’s recent UK assessment
in writing, and what Lagarde said in public, was widely noted at the time). What
really surprised me was this post
from Dani Rodrik, who has also just visited Latvia.

Dani
Rodrick’s post goes into more detail about recent Latvian macroeconomics. In
particular, he suggests that despite the massive decline in GDP and huge rise
in unemployment, the economy may still have not completely regained the
competitiveness they lost in the preceding boom. So, in terms of the evidence,
he sees what I see if not worse. But then he says this.

“The main lesson I take from all this is the need to avoid
easy generalizations that do not respect country peculiarities. Fiscal
austerity missionaries are surely off base when they say Latvia’s experience
decisively proves Keynesians and advocates of currency depreciation
wrong. It is too early to judge the Latvian experience a success.
But it is also too early to say Latvia has been a failure.
Growth may continue, in which case the country will look better and
better.”

When
someone like Dani Rodrik looks at the same facts, but comes to rather different
conclusions than me, I get worried that perhaps I’m wrong. It is also wise to
heed Brian Ashcroft’s warning,
that small countries do have different characteristics to larger countries. With
this in mind, let me go through some of my own macroeconomic reasoning
carefully.

Was the
depth of the recession inevitable given the preceding boom? Paul Krugman is perhaps
a little too dismissive
on this point. The economy clearly was overheating in 2007/8, which is why it
became uncompetitive. At the very least, inflation had to come back to a
reasonable level. In principle this need not require any subsequent deflation
if we have a totally credible macroeconomic policy, a suitable devaluation and
a completely forward looking Phillips curve, but that is an idealisation. So
some recession was probably inevitable, as it has been for many Eurozone
countries. But in 2008/9 Latvia suffered the worst loss of output in the world!

The key
issue is not that Latvia had to get inflation down, but that having done that
it also needed to regain competitiveness. It is here that the macroeconomics of
a short sharp recession with a fixed exchange rate looks so bad. To see why,
think of the following little experiment.

We have
an economy, which through overheating has become uncompetitive. It needs to get
its prices in Euro terms down by, say, 20%. The government has dealt with the
overheating: the output gap is now zero and inflation is at its competitors’
level. But prices are still 20% too high.

The least
cost option is to devalue the currency by 20%. Now it would be foolish to
believe that is all you need to do. Restoring competitiveness will boost
demand, so to prevent the overheating starting up again you need to undertake
deflationary policy of some kind. You may also need some negative output gap
because higher import prices will raise price inflation. However you do not need
a 20% decline in output.

But
suppose we take the fixed exchange rate as given. Even in this case, a short
sharp recession makes no macroeconomic sense. Suppose that, for given inflation
expectations, a 1% output gap will reduce inflation by 1%. A short sharp shock
of output 20% below potential for a year will give you -20% inflation in that
year, so you will have restored competitiveness quickly, but at great cost. Now
think about spreading the correction over two years.

To see
how that works, we need to say a bit more about the Phillips curve. As we
discovered in the 1970s, inflation today depends not just on the output gap,
but also expected inflation. Suppose our Phillips curve is of the modern New
Keynesian kind, so this year’s inflation rate depends on next year’s expected
inflation, and let’s assume people are pretty rational in forming their
expectations. What if we have an output gap next year of -10%. This will mean
that inflation next year will also be -10%. But this year we do not need any output
gap at all. Inflation will still be -10%, because expected inflation is -10%.
So we get our competitiveness adjustment over two years, but at half the cost
in terms of lost output.

Is my
assumption about rational expectations critical here? No. Imagine instead that
the Phillips curve is of the old fashioned kind, where expectations are naive
and backward looking, so current inflation effectively depends on past
inflation. In this case we need an output gap of -10% this year, but then
nothing next year, and we still get our correction over two years at half the
cost. (We have to do something to get inflation back up after two years in this
case, but that is not important to the point I’m making.)

Now
this is all very stylised and partial equilibrium, but there is one important
message that will survive complications. The Phillips curve tells us that reducing
the price level gradually over time
is more efficient than doing it quickly. So even if you believe that you have
to stick with a fixed exchange rate, a short sharp recession is much less
efficient than a more modest but prolonged recession. Thinking about the
convexity of the social welfare function reinforces this point.

As a
result, even if output growth this year and next year was over 5% p.a., and the country achieves a sustainable level of competitiveness, I would
not call the Latvian experience a success story. The competitiveness correction
will have cost the economy a huge amount in wasted resources and unemployment
misery, when it could have achieved this correction at a much reduced cost.

Friday, 8 June 2012

Antonio
Fatás makes a significant point
about countercyclical fiscal policy. The set of economists and policy makers
who think favourably of automatic stabilisers (the fact that taxes go down and
government benefits go up in a recession, and vice versa) is very large. The
set that think discretionary countercyclical fiscal policy is desirable is much
smaller. Yet they involve the same mechanisms. It would be quite illogical to
claim that discretionary fiscal policy will have no impact on output, and at
the same time argue that automatic stabilisers do help stabilise output.

However,
there are two good reasons I can think of why you might be in favour of
automatic stabilisers but be against discretionary countercyclical fiscal
policy. The first is rather dull. Automatic stabilisers kick in fairly quickly:
if you become unemployed, you stop paying income tax and start receiving
unemployment benefit almost immediately. Discretionary fiscal policy, on the
other hand, is subject to important implementation lags. These may be political
– a bill has to be passed by politicians – or institutional – projects need to
be found to spend the money on. If we really wanted to conduct discretionary
fiscal policy on a regular basis then these lags could be considerably
shortened by making institutional changes, but in the absence of these changes
the lags are important. (They can be partially offset by expectations effects,
but clearly there is no point stimulating the economy after it has already
recovered.) Campbell Leith and I did some calculations to assess the importance
of these lags in some (unsubmitted and therefore unpublished!?) work here.

The
second good reason is more interesting. Discretionary fiscal action can be
asymmetric. Governments may be very keen to cut taxes and increase spending in a
downturn, but less interested in doing the opposite in a boom. Automatic
stabilisers, on the other hand, are pretty symmetrical. As a result,
discretionary fiscal policy can lead to deficit
bias. I argued
(see, in particular, section 4) more than a decade ago that, of the many
arguments that can be used against discretionary countercyclical fiscal policy,
these two were probably the most important for economists precisely because
most economists were in favour of automatic stabilisers.

Ironically,
that asymmetry in countercyclical fiscal policy may make a good deal of sense
in a world of low inflation targets where there is a danger of hitting the zero
lower bound (ZLB) for interest rates. When there is not that danger, we rely on
monetary policy to do our business cycle stabilisation, for all the reasons I
outlined here.
If there is a good chance that we could hit the ZLB, on the other hand, it
would be prudent to undertake expansionary fiscal policy as a precautionary
measure. (It should be undertaken in advance partly because of implementation
lags.) That means that in normal times (i.e. when we are not at the ZLB) it
makes sense to gradually reduce the stock of government debt – even if it is
not thought excessive – so as to allow for expansionary fiscal policy when the
economy is hit by large negative shocks. The argument is elaborated here.

For a
member of a monetary union, however, countercyclical fiscal policy should be
symmetrical, and it was the failure to understand this which was in my view
a major cause of the current Euro crisis. In that 2000 paper I
argued that one way of avoiding deficit bias would be to give central banks the
ability to temporarily change a small number of fiscal instruments. Perhaps not
surprisingly, I have found
this proposal to be rather unpopular among politicians. However, I think it
would have had considerable merit if it had been part of the Euro architecture.
If nothing else, it would have given something for all those national central
banks to do after the ECB was formed. More seriously, it might have helped
reduce the scale of the crisis the Eurozone now finds itself in.

Thursday, 7 June 2012

The
outcome of the ECB meeting yesterday was rather more positive than I had
hoped. Why? Because the decision to do nothing was not unanimous. That’s it I’m
afraid, but my expectations beforehand were very low. One reason was reading
this short speech
by Jörg Asmussen, a member of the Executive Board of the ECB. (HT
P O Neill) It was delivered in Riga, and extols the path of internal
devaluation and austerity taken by Latvia.

Let me
quote, to give you the flavour. “From 2008, Latvia was faced with the deepest
recession in the world. The cumulative output decline was 24%; unemployment
peaked at 20%. Keeping the euro peg was considered by many as a “mission
impossible””. “External devaluation was presented as the only way forward. But Latvia
did not choose the easy “quick fix”. It embarked on a courageous fiscal
consolidation path and structural reforms. Two years later, the speed of
the economic rebound is as extraordinary as the depth of the recession. Against
all the odds, Latvia recorded a real GDP growth rate of 5.5% in 2011.”

An
extraordinary success story: after an 18% decline in GDP in 2009, and flat GDP
in 2010, we now have 5.5% growth in 2011. But surely I’m being economical with
my quotes here. Isn’t the 5.5% growth last year just the beginning, with the
economy achieving a new dynamism. Mr. Asmussen does not provide any additional
evidence on this. Perhaps wisely, as the IMF are predicting 2% growth this
year, and 2.5% next year. So the 5.5% growth last year is all we have.

Mr.
Asmussen could have talked about unemployment, which has also fallen rapidly, from
a peak of 20% to 15% currently. Perhaps he did not, because unemployment shows
more clearly what has actually happened. We have had a huge recession, followed
by a much more modest recovery. And, as we might guess, there is apparently
much more talk
about structural unemployment in Latvia today. For a rather more objective
account of the Latvian experience of internal devaluation, see this (US) CEPR
study, or a number of Paul Krugman's posts.

Earlier this year I wrote
that when growth returned, some would say this proved those pessimistic
Keynesians had been all wrong. I must admit the ‘some’ I had in mind were politicians
and journalists, not senior central bankers. By this logic, an even better
strategy is to close the whole economy down for a year. The following year we
could get fantastic growth as the economy starts up again.

But the really scary thing about
this speech is the lesson Mr. Asmussen draws from Latvia’s ‘success’. “The
Baltic experience shows clearly that speed is of the essence. In all three
Baltic countries, the government reacted swiftly to the deterioration of public
finances and frontloaded fiscal adjustment. With a budget consolidation of
around 9% of GDP in 2009 alone, Latvia’s effort is unparalleled in Europe.”
So, Ireland and Greece, you know where you went wrong. You have been far too
tentative with your austerity.

The language is indicative. We
have a “courageous fiscal consolidation path”, “it is better to take the
medicine right away than to let the fever rise for months”, and “Latvia’s
effort is unparalleled”. Perhaps we can
describe this as ‘masochism macroeconomics’. Or is it faith in the
macroeconomic afterlife: penury (a massive waste of resources) today bringing
virtue (austerity and structural reform) that promises redemption (wealth
creation) in the distant future.

So this is why I was pleased to
hear that the ECB’s decision had not been unanimous. At last, some policymakers
in Europe do not believe this dangerous nonsense any more.

Postscript. Mark Weisbrot at the Guardian alerts us to Christine Legarde singing from the same script, alas.

Tuesday, 5 June 2012

In two
earlier posts (here
and here)
I looked at issues involving debt and intergenerational equity. The second
attracted a lot of interesting comments. Some had difficulty with the idea of
debt as a burden, and I think one way to help here is to look at pension
schemes. (I hope to return to other comments later.)

When I
talk about intergenerational equity to students, I go through all the ways that
the current generation is exploiting future generations, like climate change,
rising house prices, and rising government debt. I also say that of course the
older generation could just get the younger generation to pay them directly. I
then reveal, to the surprise of some, that that is exactly what happens in many
countries because these countries run unfunded pension schemes.

An
unfunded scheme is where the working generation pays social security
contributions, and that money goes straight into paying the pensions of the old,
rather than buying some kind of asset (hence unfunded). When the scheme starts,
the current old receive a windfall: a pension without having contributed
anything. The young pay contributions, but then receive a pension when they get
old from the new younger generation. So the older generation when the scheme
starts are clearly winners, but are there any losers? The answer depends on two
things.

The
first is whether the scheme ever stops. If it stops, the young in the period
beforehand are clear losers. They paid contributions (which went straight to
the then old), but get nothing when they get old. Obviously the scheme is a
huge burden on this ‘final generation’. However if the scheme goes on forever,
there is no last generation, so there is no loser on that account.

The second issue is whether those
who are forced to save by contributing to the pension lose out because they
could have done better saving for themselves. That in turn depends on whether
the rate of interest (r) is greater than the rate of growth (g). Those who
contribute to the pension scheme get back more than they put in because of
economic growth. The income of the young as a whole will be higher either
because of technical progress which raises income per head (assuming
contributions are a fixed proportion of income), or because there are more of
them which raises the number of heads. In either case the current young generation
contributes more than the old did when they were young, so the old benefit from
that extra money. However if they had saved themselves their return would be
the rate of interest. So if r>g, each generation of young lose out a bit by
being forced to save in a way that produces a return equal to g rather than r.

All that is happening here is
that money is passing from one group to another, with the government acting as an
intermediary. Society is ‘paying itself’. But this statement says nothing about
intergenerational equity. Suppose the scheme only lasted one period. Money
passes from the young to the old, but it would be absurd to say that this
implied that the young were not losing out.

Those who read this earlier post
will see the parallel with the case of government debt. With pensions the young
get an implicit promise that they will receive their money back with a return
equal to g, whereas those that buy debt get an explicit note saying they will
get their money back with some rate of interest r. The implicit/explicit thing
is not crucial here – after all the government can default! The key difference
is that, if people are to buy the debt voluntarily, they get a return equal to
the return on other forms of saving (=r). If r>g, taxes have to rise to make
up the difference between the two when debt is issued.

An unfunded pension scheme has
the same macroeconomic costs that I discussed before
in relation to government debt. In particular, if the young save at least part
of their pension this way, they will save less in productive capital, and if
the amount of capital in the economy as a whole is less than the optimal level,
this will be an important cost. In addition, to the extent that the
contributions act like an income tax, it can distort work effort.

Does this mean that an unfunded
pension scheme is a bad idea? You can see why it might be introduced even if it
was a bad idea – its introduction is great for the current old, so they will
always vote for it. There are two potentially important benefits, if the
alternative is funded private schemes. First, it takes away a lot of the
uncertainty in funded schemes. If you buy your private pension when the stock
market is high, and retire when it is low, you could lose out in a big way. You
might also want insurance against labour income risk. (See, for example, this paper by
David Miles.) Second, it provides a safety net for those who were misguided
enough not to contribute to a private pension. (For a useful reference on pension issues, seeOxford Review of Economic Policy Vol 22, No1, Spring 2006.)

I think
this nicely illustrates why intergenerational equity can never be the
overriding concern when it comes to issues involving government debt or
unfunded pension schemes. There are many other factors to consider that may be
more important. If it was decided that the costs of unfunded pension schemes exceeded
the benefits (or, more realistically, that the balance should move to funded
schemes), then the generations involved in any transition would almost
certainly lose out. They would become like the final generation in my
discussion above. That issue of intergenerational equity should be important in
any decision, but it should never be the only consideration.

Saturday, 2 June 2012

There
is a wonderful scene
is the film Being There,
where the innocent gardener played by Peter Sellers is asked by the President
whether he should stimulate the economy. I thought of this while wondering why
central banks seem to be gripped by inactivity as the global economy looks more
perilous by the day (see R.A. here).
I remembered being equally puzzled
by the actions of the UK’s Monetary Policy Committee at a similar time last
year, when they almost voted to raise interest rates, and by the ECB that did
raise rates. On both occasions spring was in the
air, and when much of the natural world is coming back to life, perhaps central
bankers are filled with undue optimism about economic growth. This led me to
think of Being There.

I
doubt, however, if this hypothesis would survive econometric testing. A better hypothesis, which I talked about here,
is that central banks take inflation targeting rather more literally than
economists thought they did. Actually,
we probably suspected this of the ECB, but I really did believe that both the
Fed and MPC saw themselves as pursuing ‘flexible inflation targeting’, which
meant also being strongly influenced by the output gap. Perhaps I was naive,
but in the case of the MPC I know these people, and they are all really good
economists who know what optimal policy is all about.

Perhaps
my naivety partly comes from underestimating the influence of public
accountability. With an explicit inflation target, the performance of the MPC
is judged by most of the media as success in meeting that target. Very few non-economists
blame the continuing recession on monetary policy, but the MPC has had a really
hard time as a result of underestimating inflation. As I said here,
forecast errors are generally down to bad luck rather than incompetence, but
that is not widely recognised.

It is
true that knowing what the output gap is at the moment is very difficult, but
that should not mean that you ignore it. As I argued here,
at the Zero Lower Bound (ZLB) output gap uncertainty should make you more
inclined to pursue an expansionary policy. Another factor I suspect is having to rely on Quantitative Easing to stimulate the economy. The
impact of QE is very uncertain, the numbers involved are very large, and we
should not discount the influence of those who look at these numbers and say hyperinflation is nigh. Other possible factors were
mentioned in that earlier post.

But
these are explanations, not excuses. In that earlier post I talked about
central projections. However the MPC prides itself (and quite rightly) on
stressing the uncertainty of forecasts by using its famous fan charts. It was
therefore with some surprise to read,
via Britmouse, that one member of the MPC thought that “The forecasts in May
were consistent, two years out, with roughly balanced risks on either side of
the (inflation) target.” To which I immediately thought: balanced
risks, what about the Euro?

So I
went to the Inflation Report, and sure enough the fan chart shows the forecasts
for inflation pretty evenly distributed around 2%. I then read the section on
uncertainty. I’ll be honest here – this is normally part of the report where I
tend to skip. It is full of platitudes like ‘Inflation depends on X, and X
could be higher, but then again it might be lower’. I found “..the
biggest risks stem from developments in the Euro area..” which is consistent with Mervyn King's recent remarks. But
then I read this “As was the case in past Reports, the MPC sees no meaningful way to
quantify the size and likelihood of the most extreme outcomes associated with
developments in the euro area and they are therefore excluded from the fan
charts.”

This is
something I should have picked up before, but as I said that is my fault. As a
principle it strikes me as a little odd – we try and quantify uncertainty,
unless it’s really important! But it also raises an immediate question. If the
forecast probabilities are evenly distributed around 2% without allowing
for a really bad Euro outcome, what allowance was the MPC making for this bad
outcome when deciding not to undertake further QE? I would have thought that, as the Inflation Report says that a bad Euro outcome would reduce output, the MPC also
believes this bad outcome would reduce inflation. So, making some allowance for
this would reduce expected inflation below the 2% target. So what
happened to this downside risk?

I cannot think of an answer. Perhaps there is some equally large but imponderable
uncertainty on the positive side, which can be set against a bad Euro outcome. If
there is, I think we should know about it, if only to cheer everyone up. But maybe it’s just that spring
air.

Friday, 1 June 2012

Part of
the austerity mindset that I talked
about in the context of the Irish referendum is the belief that transfers
from creditors to debtors are unfair (HT MT) because they result from the feckless
behaviour of the debtor. There is a clear parallel with the attitude to benefit
recipients within a society, which Chris Dillow talks about here.
I do not want to get into the economics or politics of attitudes of this kind,
but just claim that they are important in influencing policy, a position I think David
Glasner supports here.
Instead I want to confront this mindset with an alternative moral
tale. Let’s talk about the Core countries and the Periphery, because I want to
look at why they became creditors and debtors.

When
the Euro was formed, its fiscal architecture was embodied in the Stability and
Growth Pact (SGP). This architecture was the construction of the Core, not the
Periphery. In political terms, it was the price that the low inflation countries
of the Core laid down for their participation in the Euro. That fiscal architecture
was all about containing deficits, and said nothing about using fiscal policy
to control domestic demand. To many economists, this was something of a
surprise. Much of the academic work leading up to the formation of the Euro had
stressed the crucial role that countercyclical policy could play in reducing
the consequences of asymmetric shocks in a monetary union. The SGP effectively
ignored that work.

Why?
Perhaps because in the debate on the wisdom of setting up the Euro, the problem
of asymmetric shocks (or asymmetric adjustment to common shocks) was the key
argument used by the anti-Euro camp. So it was easier to deny that the problem
would arise, rather than talk about how it might be reduced. However I suspect
countercyclical fiscal policy was also ignored because many in the Core just
did not believe
in the kind of Keynesian world in which the policy worked. In that sense, we
were seeing the forerunner to a belief in expansionary austerity. To put this
in simple terms, the view was that any demand and competitiveness imbalances
would be quickly self-correcting, as uncompetitive countries would lose
exports, output would fall and inflation would decline. The Keynesian view that
this self-correction might be slow, costly and painful, and that fiscal policy
could reduce those costs and pain, was discounted.

Much
the same can be said about monetary policy and the ECB. This was designed by
the Core. The ECB was independent of government, but also explicitly prevented from
acting as a lender of last resort to governments.

After
the Euro was formed, interest rates came down substantially in the Periphery.
There was a substantial amount of lending by the Core private sector to the Periphery
private sector. This led to inevitable
overheating in these periphery countries relative to the core. At this point
the Core, and the bureaucratic apparatus that was essentially under the Core’s
control, should have been sounding alarm bells. But instead they continued to
follow the flawed fiscal architecture. In the case of Spain, as is well known,
the budget deficit looked OK according to these fiscal rules, so the
overheating there was allowed to continue. As a result, we got a housing and
construction bubble. The aftermath of this is what countries like Ireland and Spain
are dealing with now.

So, the
basic problem was one of excessive private sector borrowing in the Periphery, partly
financed by excessive lending by the Core. The Core countries had set up a
fiscal architecture that effectively ignored this kind of problem, and they did
nothing to address their mistake in subsequent years.

So who
is to blame? Consider a parallel with the sub-prime crisis. Do we hold the low
income households who took out mortgages they could not afford responsible for
the financial crisis that ensued? Do we blame them for the Great Recession? Do
we pity the poor financial institutions that lost money lending to these
irresponsible people? I hope not. Instead we ask, how can the financial system
have allowed this to happen? What was wrong with the architecture of
regulation, and who was responsible for this?

I think
we should have the same response to the Euro crisis. What was wrong with the
fiscal and banking architecture that allowed housing bubbles and the like in
the Periphery, and who was responsible for this architecture?

But in
the case of the Euro, it gets worse. Even after the crisis, the Core countries
continued with their anti-Keynesian mindset. As the immediate manifestation of
the crisis was unwillingness by markets to lend to Periphery governments, then
it was assumed the problem must be excessive borrowing by Periphery
governments. Never mind that the problem in Ireland was in large part because the
government bailed out its banking sector (and therefore lenders to that sector, some of whom were of course from the Core), and the problem in Spain was that it
might be forced to do the same. (On Spain, read this from Yanis Varoufakis.) So the Core countries imposed sharp fiscal
austerity on the Periphery, as the price for ‘rescuing’ these countries. It was
conveniently forgotten that the reason these countries governments found it
difficult or impossible to fund their deficits was because the common currency
denied them their own central bank, and that the ECB had been designed by the
Core such that it could not explicitly play that role. The terms of the rescue were hardly
generous, because it was argued these governments needed to learn their lesson.

It then
got even worse. The austerity inflicted on Greece led the electorate there to
believe that there was no hope down this path, and so the terms of their
particular rescue needed to be renegotiated. Impossible, responded the Core. If
you try to do that, you will have to leave the Euro. The damage that response has
done to the operation of the Euro is immense, and entirely predictable. The gains
from the ‘permanent’ abolition of exchange rate risk – gains that were central
to the economic rationale for the Euro – are being unraveled.

From
this perspective, the actions of the Core from before the Euro was formed
until the present day have been misguided and irresponsible. They risk destroying the Euro. It would not be the first time that the actions of a creditor had caused needless destruction. Bear this in mind
when you next read about how the terms of Greece’s rescue cannot possibly be
changed because of the message this would send to other Periphery countries. If
the Euro is to survive, the Core has to stop thinking like the aggrieved party,
and instead must recognise that it designed the system that, quite simply,
created this crisis.